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What Are The Tax Implications of Early Retirement?

February 18, 2024

What Are The Tax Implications of Early Retirement?

The implications of early retirement on taxes are a significant consideration for individuals who are contemplating leaving the workforce before the standard retirement age. According to the St. Louis Federal Reserve, a substantial number of Americans, approximately 3 million, opted for early retirement due to the COVID-19 pandemic. However, if you find yourself not being part of this group, it is advisable to continue working for a longer period, if possible, for two primary reasons. Firstly, working an additional year is akin to saving 2 percent of your salary for a span of 30 years. Secondly, if you do decide to retire early and need to withdraw funds from your retirement accounts, such as a 401(k) or IRA, you may be subjected to a 10% penalty tax for withdrawals made before reaching the age of 59.5. Furthermore, withdrawals from 401(k) plans and Traditional IRAs are also subject to regular taxes.


Nevertheless, if early retirement is your firm decision, there are exceptions to the 10% penalty tax for early withdrawals. In this article, we will focus on one significant exception known as the substantially equal periodic payment (SEPP) exception. We will delve into the intricacies of SEPP and discuss the impact of a recent IRS change that allows individuals retiring before the age of 59.5 to access a greater portion of their retirement funds without incurring penalties.


The Fundamentals of Exceptions Clarified


When individuals hear about IRS rule 72(t), they often associate it with the 10% early withdrawal penalty that is a part of this regulation. However, within this rule, there exist numerous exceptions to this penalty tax. For instance, consider a scenario where a 45-year-old individual wishes to withdraw $100,000 from their IRA to purchase a boat. In such a case, this person would incur a 10% penalty tax on the taxable income from the distribution.


The primary objective of this penalty tax is to dissuade individuals from withdrawing funds from their retirement accounts prematurely. The rationale behind the government and the IRS providing us with special tax advantages - such as tax deferral, tax deductions, and tax-free growth - is to encourage us to save for the period when we are no longer working, thereby reducing our reliance on government benefits.


As you may remember, the government was just one component of the three-legged stool that constituted our retirement savings - employer savings and personal savings being the other two legs. These three components are deemed essential for ensuring financial stability during retirement.


Hence, tax deferrals, tax deductions, and tax-free growth serve as incentives from the government, while the penalties for early withdrawals act as deterrents to prevent individuals from withdrawing funds prematurely and jeopardizing their retirement. 

In all honesty, although one may not appreciate the penalty tax if imposed, it can be contended that increasing the penalty to 25% could potentially yield greater effectiveness.

Thank you for your interest.


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